Our Investing in Emerging Tech series covers the need-to-know legal issues for businesses that are buying, selling, collaborating with or looking to invest in emerging tech companies. In this article, the first of our series, we cover the key areas of legal risk that investors will focus on as they carry out due diligence on a business seeking investment and practical tips to getting your business due diligence ready.
Before investing, investors will conduct due diligence better to understand the company's business and any potential risks. This is a critical step in the decision-making process for any investor. Depending on the investor and stage of investment, investors may undertake a thorough and diligent process. It can be time-consuming and considerable information may need to be provided for review.
The approach to due diligence will vary depending on a number of factors, including industry sector, the structure of the investment being made, and the growth stage of a company. That said, any investor's due diligence is likely to focus on a handful of critical areas, some of which are set out in this article. Identified risks in these areas may cause an investor to take a number actions, including withdrawing from an investment round, re-pricing an investment round, restructuring their investment or seeking additional contractual protections through the investment document. Being prepared will simplify this process enormously.
This article is intended to help early stage companies understand the key areas of legal risk that investors are likely to focus on, to simplify the process and make themselves ‘investment ready’. The below steps can be taken by a company to prepare for the scrutiny that is coming. A due diligence ready company will also reassure an investor that their money is being well invested.
This article focuses on legal and compliance due diligence. But the company should also be prepared for commercial and financial due diligence and, quite likely, tech and cyber due diligence.
Section 1 - Cap table and corporate documents
Current and up to date copies of the company's articles of association and any existing shareholders' agreements governing the company should be ready to be provided to any prospective investor, together with a pre-money capitalisation table summarising the company's capital structure. The company's capitalisation table should include all equity securities in issue and any rights to subscribe for equity securities (such as warrant instruments), all debt securities and all convertible debt securities.
Investors will also expect to see a post-money capitalisation table, showing the impact of the investment round on the company's shareholder structure, including the dilutive impact of any employee incentive schemes.
As evidence of strong corporate governance and record-keeping, investors may also wish to see minutes and resolutions documenting key decisions taken by the company's directors and shareholders.
Section 2 - Intellectual Property
Intellectual property in the products being developed by a company is a key area of value for investors and a key area of risk. This is particularly true to start-ups who have developed innovative products. Investors will be concerned to check that key intellectual property is protected and not susceptible to challenge.
This will include:
(a) ensuring that any intellectual property rights that are capable of registration have been registered; and
(b) ensuring that the employees and contractors (in particular, developers) involved in creating intellectual property have signed appropriate provisions in their employment or service agreements assigning rights in the intellectual property they develop to the company.
Practical tip: Be prepared to be asked for evidence of IP assignments. Ideally these should be obtained in advance of creating/transferring IP rights, but they can be obtained retrospectively if necessary.
Section 3 - Key customer and supplier contracts
Customers and security of revenue: Revenue breakdowns by customer, and the security of that revenue, is often an important focus which investors will want to understand, especially when investing in more mature companies. Where a business is reliant on a small number of customers for a large share of its revenue, investors will want to check key customer contracts to ensure, amongst other things, that key contracts are not soon to expire and that key customers do not have a right to terminate their contract without cause.
Especially for companies where investor interest is demonstrated by annual recurring revenue, investors will want to understand whether any terms in key customer contracts might threaten revenue security.
Practical tip: Check with external counsel whether you can disclose customer agreements with investors and, if so, at what stage. Redactions may be needed for especially sensitive commercial information.
Key and hard to replace suppliers: Where a company’s business is dependent on inputs from a concentrated number of key suppliers, especially where such inputs may be difficult to replace on similar terms from other suppliers, investors will want to better understand the security of that supplier arrangement. Key supplier agreements should be collected and made available through the data room in advance.
Practical tip: Check renewal dates for supplier agreements and engage with suppliers early to ensure plenty of time to negotiate fee increases.
Faith in a company's core team is a common driver for investor interest. Investors will want to see that all critical persons (e.g. founders and senior management) have signed service agreements on appropriate terms.
Features that investors will want to verify include:
(a) restrictive covenants if the employee leaves the employment of the company, to stop them from competing with the company or soliciting other employees of the company to leave; and
(b) as described above, that any rights in intellectual property generated by the company's employees belongs to the company and not the relevant employee.
Advice from counsel should be taken to ensure that restrictive covenants entered into by employees do not go too far. Otherwise, they risk being unenforceable.
Key policies and procedures, including employee handbooks, workplace policies and information on key employee benefits may be requested by an investor, to better understand the company's values and ethos.
Practical tip: Consider data protection laws before disclosing information that identifies individual employees. A company may be able to rely on legitimate interests to disclose personal data in this context, but this will not apply to special categories of personal data (e.g. health data and data about a person's racial or ethnic origin), so any information of this nature should be redacted.
Investors will expect fulsome information on any current, former or threatened disputes against the company, with a heightened focus on:
(a) disputes with key customers or suppliers;
(b) large disputes which could have a material impact on the financial position of the company; and
(c) disputes or grievances (including employee disputes), where these might be expected to have a reputational impact for the company or investor if made public.
Summaries of any such disputes should be prepared in advance and included in the data room. Where disputes are ongoing and the company has concerns that sharing information may compromise legal advice privilege, the advice of counsel should be taken before sharing such information.
For companies in a regulated sector, notably fintech, regulatory compliance will often be the main focus of an investor’s due diligence. Investors will be sensitive to the fact that a fintech may be at an early stage in its development. But a long list of compliance failings or evidence of a poor compliance culture will alarm investors. Many an investment has failed – or become significantly more difficult – because of regulatory findings.
More generally, an investor will likely wish to see certain key policies and procedures adopted by the company, such as its anti-bribery and corruption and anti-money laundering policies. If the company processes material quantities of personal information, investors will expect to review the company’s data protection policies and procedures and any incidents will be scrutinised carefully. A company should also expect to answer questions on sanctions.
Practical tip: For many early stage businesses, compliance is a work in progress. Be prepared to demonstrate that you have a plan in place and are taking steps to address areas of weakness. Investors will want to see that compliance is taken seriously.
Section 7 - Environmental, Social, and Governance (ESG) factors
ESG considerations are important for many investors, especially those, such as “Article 9” funds, who are pursuing a sustainable or net zero investment strategy. If a company is seeking investment from an investor with an ESG focus, they may want to better understand the company’s environmental impact and sustainability practices, relationships with its employees, customers and communities and any policies and processes to improve transparency and accountability in the company’s decision making.
Practical tip: If the investor intends to hold its investment within a fund with ESG disclosure obligations, the ESG due diligence will be specific and detailed and you should be prepared for more extensive enquiries if that is the case.
